Due Process Limits State’s Power to Tax Out of State Trust

In North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, the U.S. Supreme Court was asked to review North Carolina’s attempt to tax an out-of-state trust. Justice Sotomayor, writing for a unanimous court, said the case was about the limits of a State’s power to tax a trust.

“The North Carolina courts interpret this law to mean that a trust owes income tax to North Carolina whenever the trust’s beneficiaries live in the State, even if—as is the case here—those beneficiaries received no income from the trust in the relevant tax year, had no right to demand income from the trust in that year, and could not count on ever receiving income from the trust.” Affirming the decision below, the Court held that the tax, as applied under the facts in this case, violated the Fourteenth Amendment’s Due Process Clause.

Nearly 30 years before the case landed on the Supreme Court’s steps, Joseph Lee Rice III formed a trust for his children. He did so in New York and the trust was governed by New York law. A fellow New Yorker was appointed trustee. The trust gave the trustee absolute discretion to distribute the trust’s assets to its beneficiaries in such amounts as the trustee deemed appropriate.

There were no North Carolina beneficiaries when the trust was created. In 1997, Kimberley Rice Kaestner moved to the tar heel state. Kim and her minor children resided there from 2005 through 2008, which were the years North Carolina sought to tax. Meanwhile, in 1992 the trustee had divided the initial trust into three subtrusts in 1992, one being for Kim and her children. While Kim was living in North Carolina, the trustee – still in New York – chose not to distribute any income to Kim or her children. There were no trust assets in North Carolina. The 1992 trust was to continue until Kim attained the age of 40, which occurred after the tax years in dispute.

Although North Carolina’s tax law imposes a tax on any trust income for the benefit of a North Carolina resident, the North Carolina Courts held that in this case, under these facts, the link between the trust and North Carolina was too tenuous. The “State Supreme Court reasoned that the Kaestner Trust and its beneficiaries “have legally separate, taxable existences” and thus that the contacts between the Kaestner family and their home State cannot establish a connection between the Trust “itself” and the State.”

The U.S. Supreme Court said its Due Process analysis borrows from International Shoe which requires minimum contacts between an involuntary party and a State before the State can assert jurisdiction. In the context of tax law, a State has power to impose a tax “only when the taxed entity has “certain minimum contacts” with the State such that the tax “does not offend `traditional notions of fair play and substantial justice.” The test is whether the party being taxed derived benefits and protection from the State asserting the right to tax.”

Here, the Trustee was in New York. The trust investments were either in New York or Massachusetts. There were no investments in North Carolina during the tax years in question and no distributions were made to the beneficiaries during the years in question. The only connection between North Carolina and the trust was that its beneficiaries lived there. However, prior cases held that “[w]hen a State seeks to base its tax on the in-state residence of a trust beneficiary, the Due Process Clause demands a pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax.” Applying the principles discussed, the Court held that Kim’s residency in North Carolina alone does not supply the minimum connection necessary to tax trust income.